Rolling Fiscal Cliffs Ahead

They say that when something sounds too good to be true, it probably is. The financial markets seem to think that the U.S. government has moved beyond the stress and woe of December's confrontation over the fiscal cliff.

The S&P 500 and the Dow Industrials have moved past the levels of 1500 and 14,000, respectively. They remain just short of the all-time highs of 1565 and 14,164 that they achieved on Oct. 9, 2007, but investor psychology is positive. Both indices seem poised to move into record territory. It's a bullish start for the year that should point to a strong year overall. But does it?

The reality is that there is plenty of stress and woe from Washington yet to come. Far from resolving its problems, the nation's capital is simply moving on from a one-time risk of steep automatic tax increases and spending cuts to a new set of risks that could be just as disruptive. These involve two different ways of forcing the government to cease operations. One is by letting the government run out of borrowing authority, which could also entail a default in U.S. bonds when the statutory debt ceiling is reached. The other is by letting the government run out of spending authority, which is what happens when the continuing resolution that currently provides funding for government agencies expires on March 27. The scary thing about these fiscal crises is that they can repeat. Sen. Ron Wyden (D-Oregon) calls them "rolling fiscal cliffs."

Points of Failure

There are some speed bumps ahead of Congress in the coming months. The first is the sequester called for in the Budget Control Act that was postponed for 60 days in the fiscal cliff deal. If Congress wished to avoid a round of spending cuts designed to be as painful and indiscriminate as possible, it might use the occasion to negotiate a comprehensive, long-term debt and deficit reduction deal, which the Simpson-Bowles Commissions recommended in December 2010. But don't hold your breath. We are inclined to think that Congress won't jump at the opportunity. Instead, the sequester is more likely than not to happen.

Second is the continuing resolution (CR), which is set to expire on March 27. Given that funding for the entire government is involved, the CR provides a more compelling opportunity to reach a debt reduction deal. But we don't think that Congress is going to be ready by that date either. Republicans feel that they have already made their concessions on taxes in the fiscal cliff deal, which included an increase in tax revenues and in the top tax bracket. Democrats have backed away from any entitlement changes that would curb spending over time. Yet any meaningful debt reduction deal will need to include new revenues, tax reform, and restructuring of entitlements.